The benefits of free-trade have been most evident in developing countries

Short-term effects on financial markets may be reversed in the long run

The net impact on global growth will be negative

The success of free-trade and globalisation has been a boon for less developed countries but, to judge by the behaviour of the developed world electorate of late, this has been at the expense of the poorer and less well educated peoples of the developed nations. Income inequality in the west has been a focus of considerable debate among economists. The “Elephant Chart” below being but one personification of this trend:-

What this chart reveals is that people earning between the 70th and 90th percentile have seen considerably less increase in income relative to their poor (and richer) peers. I imagine a similar chart up-dated to 2016 will show an even more pronounced decline in the fortunes of the lower paid workers of G7.

The unforeseen consequence to this incredible achievement – bringing so many of the world’s poor out of absolute poverty – has been to alienate many of the developed world’s poorer paid citizens. They have borne the brunt of globalisation without participating in much, if any, of the benefit.

It can be argued that this chart is not a fair representation of the reality in the west. This excellent video by Johan Norberg – Dead Wrong – The Elephant Graph – makes some important observations but, as a portfolio manager, friend of mine reminded me recently, when considering human action one should not focus on absolute change in economic circumstances, but relative change. What did he I mean by this? Well, let’s take income inequality. The rich are getting richer and the poor are…getting richer less quickly.

In the dismal science, as Carlyle once dubbed economics, we often take a half-empty view of the world. Take real average income. Since 2008 people have become worse-off as the chart below for the UK shows:-

Source: Economicshelp.org

However, in the long-run we have become better-off for generations. What really drives prosperity, by which I mean our quality of life, is productivity gains: our ability to harness technology to improve the production of goods and services.

Financial markets are said to be driven by fear and greed. Society in general is also driven by these factors but there is an additional driver: envy. Any politician who ignores the power of envy, inevitably truncates his or her career.

The gauntlet was thrown down recently by the new US administration: their focus was on those countries with trade surpluses with the US. Accusations of trade and currency manipulation play well to the disenfranchised American voter.

Well before the arrival of the new US President, however, a degree of rebalancing had already begun to occur when China adopted policies to increase domestic consumption back in 2012. A recent white paper entitled – Is the Global Economy Rebalancing? By Focus Economics – looks at the three countries with the largest persistent current account surpluses: China, Germany and Japan. As they comment in their introduction, a current account surplus may be derived by many different means:-

Decades of conflicting perspectives over the causes and effects of global trade imbalances have been thrust back into the spotlight in recent months by Donald Trump’s brazen criticism of almost every country with a significant current account surplus with the U.S. His controversial accusation that big exporter countries are deliberately weakening their currencies to gain a competitive advantage taps into an issue that has perplexed and divided economists and policymakers ever since the mid-1990s. At that time, countries such as the U.S. were starting to build up large current account deficits, while others such as China, Germany and Japan were accumulating large surpluses.

Put simply, a country’s current account balance measures the difference between how much it spends and makes abroad. Trade in goods usually—but not always—accounts for most of the current account, while the other components are trade in services, income from foreign investment and employment (known as ‘primary income’), and transfer payments such as foreign aid and remittances (known as ‘secondary income’).

A current account surplus or deficit is not necessarily in and of itself a good or bad thing, since a number of considerations must be factored in—for example, in the case of deficit countries, whether they make a return on their investments that exceeds the costs of funding them. A large current account surplus can be considered a desirable sign of an efficient and competitive economy if it comprises a positive trade balance generated by market forces. And yet such competitiveness can also be falsely created to an extent by policy decisions (e.g. a deliberate currency weakening), or may alternatively be a sign of overly weak domestic demand in a highly productive country. Therein lies the crux of the controversy, or at least one of many.

Global imbalances were a critically important contributing factor to the financial crisis, although they did not in themselves cause it. Even if the precise nature of that connection has sparked different interpretations, there is at least more or less agreement on the fundamentals of the part played by trade relations between the U.S. and China, the two countries traditionally responsible for the lion’s share of global imbalances. Credit-fueled growth in the U.S. encouraged consumers to spend more, including on products originating in China, thereby further increasing the U.S. trade deficit with China and prompting China to “recycle” the dollars gained by buying U.S. assets (mostly Treasury notes). This, in turn, helped to keep U.S. interest rates low, encouraging ever greater bank lending, which pushed up housing prices, caused a subprime mortgage crisis and ultimately ended in a nasty deleveraging process.

Services and investment balances can be difficult to measure accurately; trade data is easier to calculate. Here are the three current account surplus countries in terms of their trade balances:-

Source: Trading Economics, Chinese General Administration of Customs

Interestingly, China’s trade balance has declined despite the recent devaluation in the value of the Yuan versus the US$.

Source: Trading Economics, German Federal Statistics Office

The relative weakness of the Euro seems to have underpinned German exports. On this basis, the weakening of the Euro, resulting from the Brexit vote, has been an economic boon!

Source: Trading Economics, Japanese Ministry of Finance

The Abenomics policy of the three arrows whilst it has succeeded in weakening the value of the Yen, has done little to stem its steadily deteriorating trade balance. The Yen has risen ever since the ending of Bretton Woods, it behoves Japanese companies to invest aboard. The relative strength of the current account is the result of Japanese investment abroad.

Trade data is not without its flaws, even in a brand dominated business such as automobiles the origin of manufacture can turn out to be less obvious than it might at first appear. According to the Kogod – Made in America Auto Index 2016 – at 81% the Honda Accord ranks fifth out of all automobiles, in terms of the absolute percentage of an entire vehicle which is built in the USA, well above the level of many Ford and General Motors vehicles.

Conclusions and Investment Opportunities

The financial markets will react differently in each country to the headwinds of de-globalisation and the rise of protectionism. The US, however, presents an opportunity to examine the outcome for a largest economy in the world.

The US currency’s initial reaction to the Trump election win was a significant rise. The US$ Index rallied from 97.34 on the eve of the election to test 103.81 at the beginning of January. Since then, as the absolute power, or lack thereof, of the new president has become apparent, the US$ Index has retraced the entire move. Protectionism on the basis of this analysis is likely to be UD$ positive. In the long run protectionist policies act as a drag on economic growth. The USA has the largest absolute trade deficit. Lower global economic growth will either lead to a rise in the US trade deficit or a strengthening of the US$, or, perhaps, a combination of the two.

Interest rates and bonds may be less affected by the strength of the US currency in a protectionist scenario, but domestic wage inflation is likely to increase in the medium term, especially if border controls are tightened further, closing off the flow of immigrant workers.

US stocks should initially benefit from the reduction in competition derived from a protectionist agenda but in the process the long run competitiveness of these firms will be undermined. The continual breaching to new highs which has been evident in the S&P 500 (and recently, the Nasdaq) is at least partially due to expectation of the agenda of the new administration. These policies include the lowering of corporation tax rates (from 35% to 15%) to bring them in line with Germany, infrastructure spending (in the order of $1trln) and protectionist pressure to “Buy American, Hire American”. Short term the market is still rising but valuations are becoming stretched by many metrics, as I said recently in Trumped or Stumped? The tax cut, the debt ceiling and riding the gravy train:-

As globalisation goes into reverse, fiscal policy will take the strain

Countries with government debt to GDP ratios <70% represent >45% of global GDP

Fiscal expansion by less indebted countries could increase total debt by at least $3.48trln

…But now I only hear

Its melancholy, long, withdrawing roar…

Matthew Arnold – Dover Beach

Over the course of 2016 the world’s leading central banks have subtly changed their approach to monetary policy. Although they have not stated that QE has failed to stimulate global growth they have begun to pass the baton for stimulating the world economy back to their respective governments.

The US election has brought protectionism and fiscal stimulus back to the centre of economic debate: but many countries are already saddled with uncomfortably high debt to GDP ratios. Which countries have room for manoeuvre and which governments will be forced to contemplate fiscal expansion to offset the headwinds of protectionism?

Anti-globalisation – the melancholy, long, withdrawing roar

The “Elephant” chart below explains, in economic terms, the growing political upheaval which has been evident in many developed countries:-

Source: The Economist, World Bank, Lakner and Milanovic

This chart – or at least the dark blue line – began life in a World Bank working paper in 2012. It shows the global change in real-income, by income percentile, between 1988 and 2008. The Economist – Shooting an elephant provides more information.

What this chart reveals is that people earning between the 70th and 90th percentile have seen considerably less increase in income relative to their poor (and richer) peers. I imagine a similar chart up-dated to 2016 will show an even more pronounced decline in the fortunes of the lower paid workers of G7.

The unforeseen consequence to this incredible achievement – bringing so many of the world’s poor out of absolute poverty – has been to alienate many of the developed world’s poorer paid citizens. They have borne the brunt of globalisation without participating in much, if any, of the benefit.

An additional cause for concern to the lower paid of the developed world is their real-inflation rate. The chart below shows US inflation for specific items between 1996 and 2016:-

Source: American Enterprise Institute

At least the “huddled masses yearning to breathe free” can afford a cheaper television, but this is little comfort when they cannot afford the house to put it in.

Anti-globalisation takes many forms, from simple regulatory protectionism to aspects of the climate-change lobby. These issues, however, are not the subject of this letter.

Which countries will lose out from protectionism?

It is too early to predict whether all the election promises of President-elect Trump will come to pass. He has indicated that he wants to impose a 35% tariff on Mexican and, 45% tariff on Chinese imports, renegotiate NAFTA (which the Peterson Institute estimate to be worth $127bln/annum to the US economy) halt negotiations of the TPP and TTIP and, potentially, withdraw from the WTO.

Looking at the “Elephant” chart above it is clear that, in absolute per capita terms, the world’s poorest individuals have benefitted most from globalisation, but the largest emerging economies have benefitted most in monetary terms.

The table below ranks countries with a GDP in excess of $170bln/annum by their debt to GDP ratios. These countries represent roughly 95% of global GDP. The 10yr bond yields were taken, where I could find them, on 21st November:-

Country

GDP

Base Rate

Inflation

Debt to GDP

10yr yield

Notes

Japan

4,123

-0.10%

-0.50%

229%

0.03

Greece

195

0.00%

-0.50%

177%

6.95

Italy

1,815

0.00%

-0.20%

133%

2.06

Portugal

199

0.00%

0.90%

129%

3.70

Belgium

454

0.00%

1.81%

106%

0.65

Singapore

293

0.07%

-0.20%

105%

2.36

United States

17,947

0.50%

1.60%

104%

2.32

Spain

1,199

0.00%

0.70%

99%

1.60

France

2,422

0.00%

0.40%

96%

0.74

Ireland

238

0.00%

-0.30%

94%

0.98

Canada

1,551

0.50%

1.50%

92%

1.57

UK

2,849

0.25%

0.90%

89%

1.41

Austria

374

0.00%

1.30%

86%

0.54

Egypt

331

14.75%

13.60%

85%

16.95

Germany

3,356

0.00%

0.80%

71%

0.27

India

2,074

6.25%

4.20%

67%

6.30

Brazil

1,775

14.00%

7.87%

66%

11.98

Netherlands

753

0.00%

0.40%

65%

0.43

Israel

296

0.10%

-0.30%

65%

2.14

Pakistan

270

5.75%

4.21%

65%

8.03

Finland

230

0.00%

0.50%

63%

0.46

Malaysia

296

3.00%

1.50%

54%

4.39

Poland

475

1.50%

-0.20%

51%

3.58

Vietnam

194

6.50%

4.09%

51%

6.10

South Africa

313

7.00%

6.10%

50%

8.98

Venezuela

510

21.73%

180.90%

50%

10.57

Argentina

548

25.75%

40.50%

48%

2.99

Philippines

292

3.00%

2.30%

45%

4.40

Thailand

395

1.50%

0.34%

44%

2.68

China

10,866

4.35%

2.10%

44%

2.91

Sweden

493

-0.50%

1.20%

43%

0.52

Mexico

1,144

5.25%

3.06%

43%

7.39

Czech Republic

182

0.05%

0.80%

41%

0.59

Denmark

295

-0.65%

0.30%

40%

0.40

Romania

178

1.75%

-0.40%

38%

3.55

Colombia

292

7.75%

6.48%

38%

7.75

Australia

1,340

1.50%

1.30%

37%

2.67

South Korea

1,378

1.25%

1.30%

35%

2.12

Switzerland

665

-0.75%

-0.20%

34%

-0.15

Turkey

718

7.50%

7.16%

33%

10.77

Hong Kong

310

0.75%

2.70%

32%

1.37

Taiwan

524

1.38%

1.70%

32%

1.41

Norway

388

0.50%

3.70%

32%

1.65

Bangladesh

195

6.75%

5.57%

27%

6.89

Indonesia

862

4.75%

3.31%

27%

7.85

New Zealand

174

1.75%

0.40%

25%

3.11

Kazakhstan

184

12.00%

11.50%

23%

3.82

***

Peru

192

4.25%

3.41%

23%

6.43

Russia

1,326

10.00%

6.10%

18%

8.71

Chile

240

3.50%

2.80%

18%

4.60

Iran

425

20.00%

9.50%

16%

20.00

**

UAE

370

1.25%

0.60%

16%

3.57

*

Nigeria

481

14.00%

18.30%

12%

15.97

Saudi Arabia

646

2.00%

2.60%

6%

3.97

*

Notes

*Estimate from recent sovereign issues

**Estimated 1yr bond yield

***Estimated from recent US$ issue

Source: Trading economics, Investing.com, Bangledesh Treasury

Last month in their semi-annual fiscal monitor – Debt: Use It Wisely – the IMF warned that global non-financial debt is now running at $152trln or 225% of global GDP, with the private sector responsible for 66% – a potential source of systemic instability . The table above, however, shows that many governments have room to increase their debt to GDP ratios substantially – which might be of luke-warm comfort should the private sector encounter difficulty. Interest rates, in general, are at historic lows; now is as good a time as any for governments to borrow cheaply.

If countries with government debt/GDP of less than 70% increased their debt by just 20% of GDP, ceteris paribus, this would add $6.65trln to total global debt (4.4%).

Most Favoured Borrowers

Looking more closely at the data – and taking into account budget and current account deficits -there are several governments which are unlikely to be able to increase their levels of debt substantially. Nonetheless, a sizable number of developed and developing nations are in a position to increase debt to offset the headwinds of US protectionism should it arrive.

The table below lists those countries which could reasonably be expected to implement a fiscal response to slower growth:-

The countries in the table above – which have been ranked, in ascending order, by outstanding government debt – have total debt of $4.65trln. If they each increased their ratios to 70% they could raise an additional $3.47trln to lean against an economic downturn. A 90% ratio would see $5.78trln of new government debt created. This is the level above which economies cease to benefit from additional debt according to Reinhart and Rogoff in their paper Growth in a Time of Debt.

Whilst this analysis is overly simplistic, the quantum of new issuance is not beyond the realms of possibility – India’s ratio reached 84% in 2003, Indonesia’s, hit 87% in 2000 and Saudi Arabia’s, 103% in 1999. Nonetheless, the level of indebtedness is higher than many countries have needed to entertain in recent years – ratios in Australia, Mexico and South Korea, though relatively low, are all at millennium highs.

Apart from the domestic imperative to maintain economic growth, there will be pressure on these governments to pull their weight from their more corpulent brethren. Looking at the table above, if the top seven countries, by absolute increased issuance, raised their debt/GDP ratios to 90%, this would add $3.87trln to global debt.

Other large developed nations, including Japan, are likely to resort to further fiscal stimulus in the absence of leeway on monetary policy. For developing and smaller developed nations, the stigma of an excessively high debt to GDP ratio will be assuaged by the company keep.

Conclusions and investment opportunities

Despite recent warnings from the IMF and plentiful academic analysis of the dangers of excessive debt – of which Deleveraging? What Deleveraging? is perhaps the best known – given the way democracy operates, it is most likely that fiscal stimulus will assume the vanguard. Monetary policy will play a supporting role in these endeavours. As I wrote in – Yield Curve Control – the road to infinite QE – I believe the Bank of Japan has already passed the baton.

Infrastructure spending will be at the heart of many of these fiscal programmes. There will be plenty of trophy projects and “pork barrel” largesse, but companies which are active in these sectors of the economy will benefit.

Regional and bilateral trade deals will also become more important. In theory the EU has the scale to negotiate with the US, albeit the progress of the TTIP has stalled. Asean and Mercosur have an opportunity to flex their flaccid muscles. China’s One Belt One Road policy will also gain additional traction if the US embark on policies akin to the isolationism of the Ming Dynasty after the death of Emperor Zheng He in 1433. The trade-vacuum will be filled: and China, despite its malinvestments, remains in the ascendant.

According to FocusEconomics – Economic Snapshot for East & South Asia – East and South Asian growth accelerated for the first time in over two years during Q3, to 6.2%. Despite the economic headwinds of tightening monetary and protectionist trade policy in the US, combined with the very real risk of a slowdown in the Chinese property market, they forecast only a moderate reduction to 6% in Q4. They see that growth rate continuing through the first half of 2017.

Indian bond yields actually fell in the wake of the US election – from 6.83% on 8th to 6.30% by 21st. This is a country with significant internal demand and capital controls which afford it some protection. Its textile industry may even benefit in the near-term from non-ratification of the TPP. Indian stocks, however are not particularly cheap. With a PE 24.3, CAPE 18.6, 12 month forward PE 15.9 the Sensex index is up more than 70% from its December 2011 lows.

Stocks in Israel, Taiwan and Thailand may offer better value. They are the only emerging countries which offer a dividend yield greater than their bond yield. Taiwanese stocks appear inexpensive on a number of other measures too. With East and South Asian growth set to continue, emerging Asia looks most promising.

A US tax cut will stimulate demand more rapidly than the boost from US fiscal spending. Protectionist tariffs may hit Mexico and China rapidly but other measures are likely to be implemented more gradually. As long as the US continues to run a trade deficit it makes sense to remain optimistic about several of the emerging Asian markets listed in the table above.